Should we expect more upside in pot stock Hexo (HEXO)?

Even in a record-setting market, pot stocks have proven to be unusually powerful growth vehicles. The downside, though, is that most cannabis plays now sport sky-high valuations — many of which are frankly hard to justify from a fundamental perspective.

However, HEXO(NYSEMKT:HEXO) is one name that stands out in this regard. Despite its share price more than doubling since the start of the year, the company remains woefully undervaluedrelative to the top dogs of the industry such as Aurora Cannabis, Canopy Growth(NYSE:CGC), Cronos Group, and Tilray. In fact, Aphria is the only top-level cannabis producer with a lower estimated 2020 price-to-sales ratio than HEXO (3.2 vs. 5) right now.

Should investors take advantage of HEXO’s bargain-basement valuation or are these more expensive names at the top of the cannabis pecking order a better buy? Let’s breakdown HEXO’s long-term outlook to find out.

HEXO’s value proposition

There are three core reasons to buy HEXO’s stock as a pot investing vehicle:

As previously mentioned, HEXO’s projected 2020 price-to-sales ratio of five is dramatically lower than most of the elite cannabis producers right now. Driving this point home, the average forward-looking price-to-sales ratio across the most highly valued top-level producers — consisting of Aphria, Aurora, Canopy, Cronos, and Tilray — stands at approximately 16. Viewed in this context, HEXO’s stock is an outright bargain.

HEXO’s recent acquisition of Newstrike Brands catapulted the company to the middle of the pack in terms of peak production capacity. Prior to this deal, HEXO’s fully funded production capacity sat at around 108,000 kg/year. In the wake of this acquisition, the company now has a projected capacity of 150,000 kg/year, which puts it in the running to be the sixth largest producer in Canada.

Lastly, HEXO and Molson Coors Brewing(NYSE:TAP) formed a joint venture last year called Truss to develop nonalcoholic cannabis-infused beverages. While the commercial opportunity surrounding the cannabis beverage market remains elusive for a number of reasons, HEXO and Molson are on track to hit the ground running once Health Canada green-lights this second wave of product categories later this year. Canopy Growth and Tilray both have designs on cannabis-infused beverages through their own partnerships, but Truss could very well be the first to market.

What’s the main risk with this pot stock? HEXO may have trouble maintaining a healthy gross margin in the years ahead. Unless beverages prove to be a big moneymaker for HEXO, the company’s lower-tier production capabilities might prove to be its undoing.

The fact of the matter is that Aphria, Aurora, and Canopy all have the capacity to expand into numerous high-margin product categories simultaneously, which should be a tremendous benefit when dried flower prices eventually start to crumble due to oversupply in the Canadian recreational market.

HEXO, on the other hand, may not be able to push into other derivative product categories so easily — thanks to its strong commitment to the beverage segment and focus on maintaining a leadership position in the dried flower space.

Verdict

HEXO’s bottom of the ladder valuation clearly reflects the market’s doubts about the company’s competitive position and ability to withstand the upcoming supply glut. But that doesn’t mean the market is right in this case.

HEXO and Molson’s Truss joint venture stands to be an enormous value driver in the coming decade. After all, Molson absolutely needs Truss to be a smash hit. The beverage giant has been struggling with falling beer sales for the better part of the last decade and this situation isn’t expected to get better anytime soon. Truss, therefore, should be a top priority for Molson — a fact that bodes well for HEXO’s long-term prospects.

Bottom line: The combination of HEXO’s bargain-basement valuation and joint venture with Molson arguably make this stock one of the most compelling buys in this overheated space.

HEXO Corp. shares were trading at $7.21 per share on Thursday morning, up $0.08 (+1.12%). Year-to-date, HEXO has gained 110.20%, versus a 17.32% rise in the benchmark S&P 500 index during the same period.